Sunday, October 12, 2008
On clarity and finding the bottom
Our main argument was how Paulson could use TARP for purposes other than those described in testimony (the law, of course, already grants lots of flexibility). We figured another few days of chaos would give the Treasury de facto discretion over the plan. Now we have the fig leaf of international coordination to accomplish the same objective.
There is another turning point yet to cross, in our view. To-date, the government has taken a very inconsistent approach to saving or absorbing troubled institutions. It walled off $30 billion of assets to facilitate Bear Stearns. It did nothing for Lehman. The FDIC stranded debt holders for Washington Mutual. The FDIC provided some loss floors to save debt holders in Wachovia. The Treasury bought AIG and injected super-senior debt at exorbitant cost (LIBOR plus 8.5%, where the 8.5% is charged even on the *undrawn* portion).
Imagine you are in charge of private or sovereign wealth on the sidelines considering an equity stake in a financial institution. How do you quantify the government's potential absorption of bad assets and/or mandatory dilution in equity? You can't, so you stay on the sidelines, waiting to understand.
In order for the government to get external wealth back in the game, they need to define what they will save and what they will allow to be marked down. Only at that point will the market clear. I don't mean to suggest this is easy. The market may deem any explicit maginot line for government involvement insufficient and trigger further panic. It is, however, necessary. Until clarity is achieved, market rallies will be cautious and the money markets (including the bellwether TED or LIBOR-OIS spreads) will continue to suffer, causing damage to the economy with each passing day.
UPDATE: As suggested
Mitsubishi and the Japanese government have sought assurances from the Treasury Department that if the United States were to decide to inject money into Morgan Stanley at a later time — a possibility some analysts do not rule out — that such a move would not wipe out preferred shareholders. The Treasury has indicated that it might use some of the $700 billion bailout package to take direct stakes in banks, but it has not spelled out how it would do so.
Investors suffered deep losses when the government effectively nationalized the nation’s largest mortgage finance companies, Fannie Mae and Freddie Mac. It is unclear how far those discussion have gone or whether any such assurances would be forthcoming.
3 Comments:
By 
TigerHawk, at
Sun Oct 12, 07:08:00 PM:
That's a tall order, especially since not providing clarity seems to be part of the strategy. Meaning that Paulson and Bernanke are obviously worried about establishing precedent that could turn into "moral hazard." If you do not disclose your rationale for rescuing or not rescuing, then you minimize moral hazard, perhaps (as you say) at the expense of effectiveness.
By 
, at
Sun Oct 12, 11:39:00 PM:
By removing the 'market to market' accounting principle, the Government, as usual, had muddied the water and now assets will carry whatever valuation the holders choose.
Immediately after the rule was revoked, the bottom fell out of the credit market and loans stopped forcing the Fed to add more liqudity, beyond the $700 Billion, and it also hit the world markets. Who would lend to anyone who could place an asset on their books when the asset could be grossly overvalued?
By , at
Sun Oct 12, 11:40:00 PM:
I meant to say 'mark to market', not market to market...
